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The worst of times - for whom?

Are we really experiencing the ‘worst of times', asks Dr Dirk Sohnholz of Feri Alternative Assets. It is essential that investors put the current downturn in its proper context to gain perspective and work out realistic predictions for future returns.

Our theme is ‘the worst of times'. An optimist would say that, if now is the worst of times, then there must be better times ahead. I would also ask the question ‘For whom is it in fact the worst of times' for investors, for general partners or for particular sectors of the market?' What does ‘the worst of times' imply in the context of the private equity industry? If quoted markets fall and the general economic environment is bad, confidence suffers.

However, until recently, most private equity fund manager presentations used the non-correlation of private equity with the public markets as a major selling point. Were that the case, the private equity industry would have no problem today, because as a non-correlated asset class, it should be unaffected by public market conditions. Clearly that is not the case ‘ which may explain why the non-correlation argument no longer figures so prominently in fund manager presentations. When assessing whether these are the worst of times, it is also necessary to consider the quality of investors themselves: if significant capital has been invested in poor quality funds, then it will be a few years before the results of those poor decisions become apparent.

Feri advises private clients and institutions on fund investments which, by definition, means on how to invest in the future. IRR data, on the other hand, denotes past performance. Since there is plenty of evidence to suggest that top quartile returns in the past are no guarantee of top quartile performance in the future, we look for other indicators of performance potential. Absolute measures are desirable: if for instance a top quartile in a particular asset is going to be negative, then investors will not want to be in that segment of the market at all.

It is generally accepted that to rate and evaluate private equity funds it is necessary to consider qualitative, rather than simply quantitative factors.

According to this system, private equity funds ranked A and B are basically investment grade funds but category C funds are those we would expect to have problems. The system quantifies due diligence within a single grid format representing our evaluation rating of the absolute degree of quality of the venture and buy-out funds which are currently raising capital. According to this system, three quarters of the vehicles currently available are not investment grade. But during 1999 and 2000, funds that would not have ranked as investment grade according to our evaluations, collected huge sums of money. Those funds were not necessarily bad: the reason that they would be evaluated as non-investment grade might be that the management team, while consisting of individuals with proven track records, had not worked together before. The C category funds may still turn out to have been good investments, but we are risk-averse. This is potentially a serious issue for the private equity industry because of the influence unsatisfactory performance within that 75 per cent of funds that are not investment grade will have on investor sentiment towards private equity in the future.

The analysis highlights significant differences within market segments, as shown in the table above. By Feri's measure, there are currently no A-rated funds among the hundred or so European venture vehicles being raised. The potential risk in European venture according to this analysis is much higher than in other areas. The picture for venture funds in the US is different, reflecting the importance given to experience in the rating system. For buy-out funds, however, the proportion of investment grade funds in the US and Europe is fairly similar, indicating a lesser potential risk.

An unrelated study carried out by a university in Germany late last year provides data which, while covering only the German market, tends to support the findings from Feri's evaluation system. The study also lends weight to the suggestion that the worst of times may be yet to come. Around thirty of the 120 or so venture and private equity companies approached provided responses to the survey. Of those, 61 per cent focus on specific industries, which by definition means the funds have a higher implied risk than diversified vehicles. The study found that 47 per cent of respondents focus on early-stage investment which, according to general know-how and assumptions, is riskier than other areas. Astonishingly, given the fact that the average age of the firms in the sample was only five years, 29 per cent of them had already changed their strategies, while almost half the group had not exited a single deal. Both of these findings are alarming.

Another interesting statistic was that 13 per cent of partners in those companies had previous private equity experience, which means that a rather more significant number had no previous private equity experience. Furthermore, 42 per cent of these firms did not use any risk control mechanisms at all. Remember, these findings refer to funds and management companies which raised significant amounts of money in 1999 and 2000. Some of these funds may well produce good performance. If these new venture management groups have been supported by investors who are also new to the asset class, then that is promising for the industry going forward. However, some institutional investors will be severely burned; if, as in the past, those investors extrapolate from their own bad experiences and shun the asset class as a whole in the future, that would be very bad news indeed for the private equity industry.

Dr Dirk Soehnholz, is the co-founder and Managing Partner at Feri Alternative Assets. He has a PhD and diploma in business administration.